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Bill Gross Calls it “Shadow Banking System”

And here’s something else to worry about. Bill Gross, head of PIMCO, the world’s biggest bond fund, calls it the “shadow banking system.” He’s referring to the way money and credit fly around the globe, courtesy of the very same “sophisticated” and “free” institutions that created such prosperity for so many people in the financial industry.

Banks recognize that not all their loans will be repaid. They operate on margins of safety, with reserves set aside for when things go wrong. But in the worlds of swaps, hedge funds and derivatives…slick operators can invest billions with no margins of safety…and no reserves. The result, Gross says, could be catastrophic:

“But today’s banking system, as pointed out in recent Investment Outlooks , has morphed into something entirely different and inherently more risky. Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever. Financial derivatives of all descriptions are involved but credit default swaps (CDS) are perhaps the most egregious offenders. While margin does flow periodically to balance both party’s accounts, the conduits that hold CDS contracts are in effect non-regulated banks, much like their hedge fund brethren, with no requirements to hold reserves against a significant ‘black swan’ run that might break them.

“According to the Bank for International Settlements (BIS), CDS totaling $43 trillion were outstanding at year end 2007, more than half the size of the entire asset base of the global banking system. Total derivatives amount to over $500 trillion, many of them finding their way onto the balance sheets of SIVs, CDOs and other conduits of their ilk comprising the Frankensteinian levered body of shadow banks.”

Bill Bonner
The Daily Reckoning Australia

5 Comments

  1. kayle says:

    Wait. Wasn’t this the same guy who was hollering for a housing bailout just a few short months ago?

    http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2007/IO+September+2007.htm

    “Why is it possible to rescue corrupt S&L buccaneers in the early 1990s and provide guidance to levered Wall Street investment bankers during the 1998 LTCM crisis, yet throw 2,000,000 homeowners to the wolves in 2007? If we can bail out Chrysler, why can’t we support the American homeowner? The time has come to acknowledge that there are precedents aplenty in the long and even recent history of American policy making. This rescue, which admittedly might bail out speculators who deserve much worse, would support millions of hard working Americans whose recent hours have become ones of frantic desperation…Get with it Mr. President and Mr. Treasury Secretary. This is your moment to one-up Barney Frank and the Democrats. Reestablish not the RFC or the RTC, but create an RMC – Reconstruction Mortgage Corporation. If not, make some modifications in the existing FHA program, long discarded as ineffective. Write some checks, bail ‘em out, prevent a destructive housing deflation that Ben Bernanke is unable to do. After all “W”, you’re “the Decider,” aren’t you?”

    Oh, yeah. That *was* him,good ol’ “bail-em-out” Billy. Head of PIMCO, to whom Alan Greenspan is a consultant, right? Who lauded Bernanke as the right man for the right job?

    And if I recall correctly, according to Gross, the solution to this mess is trashing the dollar…errr, cutting rates as low as they can go.

    We’ll see how well that works out for the US, as opposed to Pacific Investment Management Co. – which to date has done VERY well off these surprising (!) rate cuts.

  2. Coffee Addict says:

    Re:CDS swaps —The holding company is most often a regulated bank. The bank typically sets up a separate corpotate entity to issue CDOs based on CDS.

    My view is that the risk for these instuments is in the medium range. I expect that whie some spectacular losses will make the headlines, the vast majority of these debts will indeed be repaid (in Australia at least).

    With the market and it’s commentators following the mob downwards, my usually bearish comments are starting to sound bullish (well at least to me).

    As I mow sit with my super in the cash asset allocation I am acutely aware of Bill’s core agruments. The money can’t stay there for long, particularly with respect to one of my industry funds. My public sector fund reports that their exposure to derivatives within the cash allocation is very low. I’m taking them at their word. Readers should obtain clarifications from their own funds with respect to the current CDS and derrivative exposures.

  3. kayle says:

    Hey Coffee Addict:

    I’m quite new to this stuff, so bear with me if you’re less concerned about it than I am…I don’t trust much coming from the big banks these days. (And yes, I’ve gotten comfy in the tinfoil hat lately.) :-)

    As the US is discovering, CDS are only as good as the protection seller that writes them. Ted Seides writes:

    “Banks claim to run hedged books, effectively serving as a market-maker in the CDS market. As should be evident from the events in subprime, even the most sophisticated systems are often unable to fully hedge risks of this size and degree of complexity. If printed materials are any indication, banks may be asleep at the switch. The “Counterparty Considerations” section in the Credit Derivatives Primer of market share leader JP Morgan is a single paragraph on the last page of the volume, which proclaims “the likelihood of suffering (counterparty default) is remote.”[xvi] (italics added)

    Hedge funds appear to be in over their heads as well….”

    http://www.nakedcapitalism.com/2007/11/counterparty-risk-problems-with-credit.html

    Essentially, there is some question as to the latitude financial firms have in marking their derivative books.

    What is the potential downside of (as you say) taking them at their word, should some “black swan” come along “unforeseen” by these bankers – which seems less and less unlikely these days?

    If I understand correctly, because of the opacity of their economics, some banks may be underestimating their derivative exposure, and their ability to cover, just as they have underestimated their “subprime” exposure…

    Why do you think the “vast majority of these debts will indeed be repaid”?

  4. Coffee Addict says:

    Hi Kayle

    My CDS comments relate to Australia.

    While the economy here continues to be pushed along by a resources boom, the risk of corporate defaults exceeding 4-6% (over the life of an instrument) remains reasonably low. Beyond the 4-6% level I understand that the equity tranches will be eaten away and mezzanine investors will start to get burnt.

    CDS based CDO’s in Australia tend to have little (if any) overseas exposure and are issued through banks such as Lehmann, Citibank, AMN Amro, ANZ. The Banks tend to set up separate incorprated entities to manage the funds. Banks potential liability is limited 1) their investment in the funds and 2) any guarantees provided to AAA- and above investors.

    My guess is that the potential liability associated with derivative exposure need to be accounted for as a note to the accounts until such time as the risk of loss becomes probable (or at least more tangible). How it is treated in the accounts of the bank depends on the 1) the national accounting standard and 2) the friendliness on the auditor.

    If a mild to moderate recession were to bed in for more than a year or so in the US, I would expect the corporate default rates there to increase tangibly. There would be a spill over effect (of lesser magnitude) into the Australian market due to trade and direct investment links and the impact on Australian companies of lower resource prices.

    With individual CDS based CDO funds typically covering 100 to 200 CDS agreements, a strong recession may (in my view) push the default rates within some funds over the magic 6% mark. Thus while the market would in these circumstances remain intact, there may also be some isolated cases of substantial investor loss.

    It would in my view take something of the order of a 1929 crash to bring this market down fully in Australia. While this remains an unlikely event, the interest rates paid by CDS based CDOs is presently insufficient to compensate for risk of loss.

    A bigger issue for these instruments at the moment is an accounting standard that requires a mark to market if there has been any previous trading in these (or other) instruments. At the moment there isn’t much of a market and no institutional investor will want to put mark to market adjustments through their Profit and Loss Statement.

  5. William Boeder says:

    At this stage, only the Banks and a couple of masterful hood-winkers could know of the intricate labyrinthian “pathway to value” among the many obscure financial instruments being touted lately, just have a gander at the “good stuff” now coming to light: in their being sold, hired, borrowed against, lent to others, security toward, ably converted to, assumed by others, yet somehow a legally tenacious tenable trading instrument?
    Such as these convoluted guess-hole bits of paper seemed to be freely available for money dealings and I guess, were happily approved of by Glenn Stevens and his head-nodders busily toiling in our highly respected RESERVE BANK OF AUSTRALIA.

    Just the right goods to negotiate in and extract percentiles or handling commissions from, as were to be traded in by Opes Prime and any other game as Ned Kelly money shop?

    Why our Bankers and highly sophisticated Stock-exchange Guru’s readily accept and use this type of tangible multi-purpose tradeable certificate, certainly confuses me?

    Life would be so much simpler if we just used money and share certificates instead of the many “newly invented black-hole futures certificates” or whatever their names are today, that are now causing so much out of control financial pain and disaster to all who touch and have touched these Bloody -#*#?%#+? things.

    William Boeder.

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